There are people who think that a stock is worth what someone will pay you for it, but that’s sort of a boring conversation. Talking about fundamental, long-term, present-value-of-future-cash-flows type values gives much more scope for debate, analysis, and fantasy. See, this company is just trading at four dollars a share. It’s worth hundreds.
Normally you make those sorts of arguments in the usual way – you buy some stock, and if others agree with you they buy some stock too, and the stock goes up, and you have yourself a Keynesian beauty contest. But Gretchen Morgenson had a fun column this weekend about an exception, the appraisal-rights process. In this process, if you don’t like what you’re getting paid for your shares in a merger, you can go to a Delaware judge and ask him to decide how much your shares are worth, and he tells you, and then you get paid that amount (plus interest). You don’t have to convince the market that you’re right about the future cash flows. Just the judge.
This is normally a pretty boutique-y thing. For one thing, to exercise your appraisal rights, you have to not sell your shares into a merger, and since appraisal takes forever you can be stuck in illiquid limbo for years. This does not work well for institutional investors, so appraisal rights tend to be the province of resentful crackpots and minority shareholders unfairly squeezed out of small private companies. Also, if you exercise appraisal rights, the court just awards you what it thinks the shares are worth, and then you gotta pay your lawyers. This creates some unpleasant risk/return dynamics – if the court concludes that the company is worth what it was sold for (which: has to be the expected case, no?), then either you or your lawyer are out of pocket for his fees; and even if you win you’re splitting your upside with the lawyer.
The result is that shareholders tend to seek appraisal rights only when they have a pretty good case, and so they tend to win. Morgenson cites a paper finding that in 40 appraisal cases from 1984 to 2004, “appraisal litigation generated a median award of 50.2 percent over the buyout price.”1
Anyway Morgenson is writing about the appraisal process for Dell, and Dell is weird. Among many Dell oddities is that some folks at the Shareholder Forum think they’ve solved the liquidity problem by setting up a trust to let the appraisal-right stub be tradeable. (And: charging a penny a share to participate.2) The idea is that rather than sit around for years with a nontransferable, impossible-to-mark right to receive some uncertain amount of money at some uncertain date in the future, you could have a transferable right to receive some uncertain amount of money at some uncertain date in the future. Which through the magic of markets then becomes easy to mark: you just see where it’s trading. After all, a transferable right to receive some uncertain amount of money at some uncertain date in the future is a pretty familiar beast. It’s basically just a share of common stock.
The concept delightfully collapses the Keynesian beauty contest: instead of predicting what [other people will predict [other people will predict […]]] Dell’s future cash flows will be worth, you predict what [other people will predict [other people will predict […]]] a Delaware chancellor will predict Dell’s future cash flows would be worth. There are only five of them, as opposed to the infinity of the market, so your odds are better I guess?
Though, how will that chancellor decide how much Dell is worth? The statute3 provides that “the Court shall determine the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation”: you don’t get credit for Michael Dell’s plans for a private Dell. What exactly this means is somewhat mysterious.4 Michael Dell’s essential argument is that Dell needs to pivot to being an enterprise business, and can’t do that efficiently while remaining public: that getting the right ownership structure is a necessary precondition to making the right business decisions.5 If that’s right, should an ex-merger valuation assume that Dell blunders along as a declining PC business? And even Carl Icahn and Southeastern’s main thesis is that Dell should lever up massively to unlock value; should shareholders get the benefit of that imaginary leverage in their going-concern non-merger valuation?
Blah blah blah. I know what I would do if I were the appraising chancellor:
- Open up Bloomberg.
- See where those Dell Valuation Trust appraisal rights are trading.
- Award that amount.
Efficient markets baby! If someone’s going to take the trouble to trade predictions of what I’ll decide, the least I can do is decide based on those predictions.6
Will this catch on? I dunno, but there’s a whole business devoted to M&A. People hire bankers and do valuation analyses and negotiated deals and end up with a price that the buyer is willing to pay and the target[‘s board] is willing to accept, and the target’s shareholders vote on it, and that’s sort of the deal. Appraisal rights tend to be a minor sideshow, creating work for the lawyers but rarely having a material impact on the actual price of a big regular-way public company merger. The assumption is that, except in unusual cases, the parties and their advisors, not a Delaware judge, get to decide how much the deal is worth.
Dell is in some ways unusual – people are hopping mad about the price, for one thing, and that plus the sheer size of the deal makes it an attractive candidate for appraisal lawyers7 – but it’s not that unusual: it’s basically a regular-way, heavily negotiated public company MBO. Here you can read the board’s revised investor deck filed today, with smiling pictures of the independent directors who independently negotiated the deal with Michael Dell and Silver Lake. They did all the things you’re supposed to do, and probably thought that they’d gotten themselves a fairly normal merger, albeit one with shareholder-lawsuit and Carl-Icahn complications. It’d be rough on Silver Lake if a court nonetheless made them pay more than they agreed to. And rough on future M&A deals, too: it’s hard to agree to a deal if the sellers always get another chance in court.
1. Obviously this is a biased sample: not every deal leads to appraisal cases, only the ones where there’s a plausible chance of success. So it doesn’t mean that, for a randomly selected deal, you should expect a 50% premium by going through appraisal. You’d hope not: if Delaware judges were on average valuing companies 50% above where acquirers were, there’d be a problem. With something. I’d argue: with the appraisal process, though I guess “acquirers in M&A systematically underpay for targets” is an alternative. Though a somewhat doubtful alternative given that, y’know, acquirers in M&A systematically overpay for targets.
2. That’s for administrative costs. I have no idea how they plan to pay their lawyers for actually litigating. Maybe they plan to win.
3. Conveniently the securities laws require companies to provide a summary of the appraisal process, and the text of the statute, in their merger proxies, so the link is to Dell’s proxy.
In determining fair value, the Delaware Court of Chancery will take into account all relevant factors. In Weinberger v. UOP, Inc., the Supreme Court of Delaware discussed the factors that could be considered in determining fair value in an appraisal proceeding, stating that “proof of value by any techniques or methods that are generally considered acceptable in the financial community and otherwise admissible in court” should be considered, and that “fair price obviously requires consideration of all relevant factors involving the value of a company.” The Delaware Supreme Court stated that, in making this determination of fair value, the Court of Chancery must consider market value, asset value, dividends, earnings prospects, the nature of the enterprise and any other facts that could be ascertained as of the date of the merger that throw any light on future prospects of the merged corporation. Section 262 provides that fair value is to be “exclusive of any element of value arising from the accomplishment or expectation of the merger[.]” In Cede & Co. v. Technicolor, Inc., the Delaware Supreme Court stated that such exclusion is a “narrow exclusion that does not encompass known elements of value,” but which rather applies only to the speculative elements of value arising from such accomplishment or expectation. In Weinberger, the Supreme Court of Delaware also stated that “elements of future value, including the nature of the enterprise, which are known or susceptible of proof as of the date of the merger and not the product of speculation, may be considered.”
5. Ooh, do you buy that? I was sort of dismissive of it last week, but there’s an argument that for enterprise IT companies like Dell hopes to be (more than for consumer PC companies like Dell hopes not to be) a declining stock price really does drive away customers (who need their IT vendor to support them for the long term) and employees (who are paid in stock, etc.). It’s less clear to me that the solution is “so do a 5x levered LBO” but so it goes.
6. No, I mean, that’s probably a bad idea. SUBJECT TO MANIPULATION and all that. But: fun?
Often purchasers limit shareholder participation in appraisals to minimize their financial exposure should a judge rule that a higher price is in order. But Mr. Dell’s offer did not limit how many shareholders could mount an appraisal case. …
“What makes this an interesting case for appraisal is you rarely see going-private deals of this size,” said Jeffrey Gordon, a professor at Columbia Law School. “If you’re a 3 percent or 5 percent owner, the litigation cost of an appraisal case for Dell is a tiny fraction of the potential upside.”
For “if you’re a 3 percent of 5 percent owner,” read “if you’re a plaintiff’s lawyer,” obvs.